The Vanguard Dynamic Spending Rule: A Closer Look at Its Pros and Cons

the Vanguard Dynamic spending rule is a retirement withdrawal strategy developed of course by Vanguard that's designed to give retirees consistency in the amount they can spend from year to year in retirement while at the same time being sensitive to market conditions and inflation in this video we're going to figure out how that rule works and we're going to put it to the test hey everybody my name is Rob Berger this is the Financial Freedom show where we talk about investing retirement and Financial Freedom if those topics are important to you I encourage you to subscribe to the channel I also send out a newsletter every Sunday morning you can subscribe to the newsletter with a link below this video so before we dive into the Vanguard Dynamic spending rule we need to put it into some context on the one hand we have the very popular four percent rule that's a constant dollar strategy meaning that you're spending the same after inflation amount throughout retirement a lot of folks like it because it's it's consistent you know you kind of know what's going to happen each year you don't have to make big adjustments to how much you're spending but there are some big downsides to the four percent rule the first one is most retirees don't spend the same amount of money on an after inflation basis year in and year out and in fact studies show that as we age say into our 80s and 90s if we live that long we tend to spend less money that's problem number one but the second one is we could actually run out of money yeah the four percent rule uh the name came from an analysis of historical U.S market and inflation data and found that that was sort of the worst case scenario the thought being if you start with four percent and then adjust for inflation thereafter you should be safe but of course we don't really know what the future holds that's another big problem with the four percent rule because it completely ignores what's going on in the market it simply adjusts for inflation each and every year even if the stock market is crashing so that's a problem on the other side of the spectrum we have an approach that says well look let's forget inflation we'll just take a fixed percentage of our portfolio every year say five percent and when the Market's up good for us we can spend a little more money the following year if the market crashes oh well we've got to cut back so the good thing is it's pretty hard to run out of money you're almost always going to have something you can apply the percentage to even if it turns out to be a smaller and smaller amount but one of the big problems is consistency one year you can have a lot to spend the next year a lot less to spend and depending on your circumstances you may not have the luxury of that sort of instability in your spending from year to year so a lot of the withdrawal strategies we talk about including today the Vanguard Dynamic spending rule tries to sort of take the The Best of Both Worlds take the stability in spending uh from the four percent Rule and the market sensitivity of the fixed percentage Rule and kind of combine them together the question is do they do a very good job with with it and is it really helpful to us in figuring out how much we can spend each year and that's what we're going to try to answer today so let's Dive Right In This is the paper the rule the um uh the rule comes from March 2017 we're going to come back to this paper in a minute and again I will leave links to everything below this video I will say the one thing that this paper doesn't actually do is walk through an actual example of using the rule which is unfortunate because there are aspects of it that I think are a little tricky that being said this Vanguard paper does walk through an example and that's what I've used to better understand the rule and uh and that's what we're going to use for today so we're going to go walk through a hypothetical and uh let's see here we're going to go to the Whiteboard and we're going to assume we'll just assume a one million dollar portfolio now we have to pick a percent that we're going to take out of the portfolio in year one and I'm going to go ahead I'm going to use five percent we'll talk about this this is an important number uh uh obviously but we're going to assume five percent so in Year One we would take out fifty thousand dollars you know so far that's not too hard to calculate right it gets harder though trust me that's going to leave us with what nine hundred and fifty thousand dollars in our portfolio at the start of year one so that's the first thing we do now the big question is after the first year how do we calculate year two and this is where uh the Vanguard Dynamic approach uses what we've talked about in the past guard rails they actually call it a ceiling and a floor and so we have to come up with a percentage for each of those I'm gonna using a some specific numbers here but we'll talk about how to maybe calculate that how to figure out what's best for you in a minute but for the ceiling we're going to use five percent that's our our ceiling and uh for the floor we're going to use two and a half percent sometimes by the way you'll see the floor expressed as a negative number I'm leaving it positive here but the point is we're going to subtract that number as you'll see in a minute so how do we actually use the stealing in the floor to come up with a range for year two well the first thing we need to do is take this whatever our spending was the previous year and adjust it for inflation so now we need to know well what was the inflation rate in the first year of our retirement so we'll just assume inflation we'll just make it five percent and so what's five percent of fifty thousand twenty five hundred so our inflation adjusted number on spending is fifty two thousand five hundred this is actually the number that we would use if we were using a constant dollar sort of Bill banking approach uh but that's not what we do here we calculate that inflation adjusted number because we need to use it to calculate the ceiling in the floor and it's pretty simple really we simply for the ceiling take this number and add in this case five percent so we can do that I'm going to actually show you I'll pull up the calculator so we'll put 52 500 in we're going to add five percent gets us 55 125. so that's our ceiling that represents the absolute most we can spend in year two under any set of circumstances the market could be up 100 doesn't matter that's the most we could spend with the Vanguard Dynamic spending Rule and then we can calculate the floor we do the same thing we put in the 52.5 and this time we subtract and our our floor percentage if you may recall is 2.5 percent and that gets us to a number that doesn't look right so I'm going to clear it out and do it again 52 500 minus 2.5 percent this looks better 51 187.50 so this is our floor so under any set of circumstances maybe the market collapse maybe inflation is high it doesn't matter this represents the lowest amount we'll have to spend in our second year of retirement and of course now the big question and frankly what I found a little confusing about the first Vanguard paper was how how do we figure out all right we've got a range but how do we figure out where in that range we're allowed to spend our money it's obviously not this number because by definition this number will always be within this range well it turns out that what we do I'm going to actually change color here for a minute is we take our our five percent remember I told you this is a very important number uh in this formula we take this five percent and we multiply it by whatever our portfolio balance was at the end of the year so in this case let's assume that our portfolio balance it's a good year and it goes up by 10 percent so if we go back to our calculator we put in our our beginning balance after we'd taken our spending out for the year was 950. we're going to add 10 percent and that takes us to a million 45 000 so we'll write that in here a million forty five thousand and then we just take that number and again multiply it by our 0.05 gets US 52 250. well we can see that that number is in between the range so we don't have to make any adjustments to it that's the number we'll have right here for the second year of retirement now obviously if the market let's just say it went down it dropped 10 percent we're going to get a very different answer as you might imagine so let's just do the numbers real quick and we'll subtract 10 percent that leaves us with eighty eight five five eight hundred fifty five thousand and then we multiply that by five percent and that gets us 42 750. now as you can see 42 750 is below our floor so significantly below our floor under the Vanguard Dynamic spending rule you would then for year two spend the floor and the idea behind this this is what you'd spend by the way if you were just following the fixed percentage rule right this is what you'd spend up here if you were just following the constant dollar bill binkin strategy but again the idea behind the Vanguard Dynamic strategy is number one it's going to be sensitive to to the market because that's what we're doing up here right we're what the market does matters to this rule but at the same time they're trying to give us some stability in spending by limiting both our upside and our downside that's the range we calculated by some amount so that's the idea behind the Vanguard Dynamic spending Rule and and to a large degree I think it works it does uh what it promises to do but the question is one and I'm going to change colors here how do we come up with these numbers these are the three numbers that are critical the percent we're gonna we're gonna multiply against our portfolio every year the percent we're going to use to calculate the ceiling and the percent we're going to use to calculate the floor and this is where I think the Vanguard Dynamic spinning rule has some challenges because while the paper we're going to go back to in a second gives us some ideas on how to set those numbers and I'll show it to you it still leaves a lot of unknowns there's not been a lot of analysis of this strategy particularly against historical data Vanguard runs simulations which I think is perfectly legitimate but this also I'd like to see a lot of historical analysis on this strategy which they don't have we are going to look at some of that in a calculator in just a minute so we'll do that but it does leave open a big question uh where do we set these numbers now let's talk about ceiling and floor one of the things that Vanguard says is that setting the ceiling is kind of more important than setting the floor if what our concern is is not running out of money and the larger the percentage you can you feel comfortable using for the floor remember that gets subtracted we use two and a half percent Vanguard tests it up to nine percent so in that case you would allow your spending to drop pretty significantly in a really bad uh year but the more you can tolerate that variability in your spending the greater the likelihood is you you won't run out of money using their strategy even with a starting initial withdrawal rate says high is potentially five percent the ceiling it matters but at least according to Vanguard and this makes some sense to me too the floor is more important of course the idea on the ceiling is you're capping your upside so when when the Market's up a lot and you could have spent more perhaps you're capping it in our hypothetical at five percent that's leaving more money in your portfolio so that you can then handle the bad years that may happen in the future so that's sort of in theory the concepts behind the ceiling and the floor that raises though another question okay what about the withdrawal rate what do we start with and what what percent do we multiply against our portfolio every year I used five percent in our uh example for a reason let me show you if we go back to this is the original paper I showed you they have a chart here now this chart I will say is based is is they created it based on running simulations not just looking at historical data and they were they were looking at achieving an 85 success rate so in other words uh they wanted to see that at least out of 10 000 scenarios they ran for each at least 8 500 of them had to be successful meaning you didn't run out of money and so the way this works is this is the Dollar Plus inflation approach that's just bill bengan and this is the Vanguard approach using the very ceiling and floor that I used and you can see why I chose the numbers I did I wanted wanted them to match and this is you know your time period 10 20 30 or 40 year retirement and here's your asset allocation um we're going to look at moderate which would basically be a 50 50. you can see the details are down here but for a moderate say for a 30-year uh retirement the the old four four percent Rule now again this was based on simulated data and an 85 success rate but this is what they come came up with with their initial uh withdrawal but using their approach with the five percent ceiling and two percent floor you could actually start with a 5.1 uh percent initial withdrawal again with that 85 percent uh success success rate using their data and their simulation now all of that is fine to me it's a pretty convoluted uh analysis we can work through it I'm I do Wonder though just how many retirees are going to want to go through all of these calculations year in and year out to try to arrive at you know a safe withdrawal rate having said that there is a free calculator you can use to sort of uh experiment with this uh withdrawal strategy I want to show you that show that to you now we've looked at it before it's called fi calc and let me show you what I've set up I've got a 30-year retirement a million dollar portfolio I've set up a 60 40 stock to bond portfolio here and I've chosen the Vanguard Dynamic spending rule it's actually the last one in their list you can click this link and it gives you some details about the rule you can see here you set the withdrawal rate you set the floor and you set the ceiling I've left it for now at two and a half and five percent the other thing I'll mention you could set a minimum annual withdrawal you could say look I may start at five percent on the million dollar portfolio but under no circumstances can I ever take out less than 25 000 on an inflation adjusted basis or whatever so you can set that here I'm not going to for our analysis so using all of this you can see it's got a not quite a 100 success rate 97.54 if we come down to the years the red years it runs out of money the yellowish brownish I don't know goldish years it almost runs out of money and then for the rest it does pretty normal if there were any years where it had a lot of money left over they'd be blue but you can see there aren't any let's look at a year that it almost ran out of money 1968. this is how much you have to spend each year and it's on an inflation-adjusted basis and you can see it starts at fifty thousand and by the time we get to year 30 we're down to 20 well we'll call it twenty four thousand dollars now the point and the reason I picked 1968 late 60s were some basically the worst time in U.S history to retire so we are looking at an extreme case but it's important that that while in theory the Vanguard Dynamic withdrawal strategy is designed to give you some consistency in spending it doesn't always work and you can see that here now again we could change the floor so for example remember this one had a almost a 100 success rate but not quite but if we drop if we increase the floor let's try four percent that gives us a success rate of 100 because again we're willing to let our spending go down even more each year if there's a bad Market uh that we have to deal with but if we go back to 1968 we can still see it's still pretty bad it does pop up a little bit towards the end but our our spending is cut by more than half on an inflation-adjusted basis and so to me I'm not sure in an extreme case that the Vanguard Dynamic spending rule lives up to its billing yes it's it's trying to give us more stability with spending and maybe it does as compared to just a fixed percentage of the portfolio but for a lot of folks this is going to be far more um drawdown than they can handle in terms of spending now of course we could change the withdrawal rate we could go to 4.5 for example and if we go to 1968 it's going to give us some more stability we started 45 000 our low water mark is around 20. again you can play with the numbers here to figure out what's best for you the point is just because it's designed to give us more consistency and spending doesn't mean that it always will now finally I'd like to just show you one other thing I've split the screen in two this is what we were looking at here we're going to go back to 1968. this is using uh the constant dollar approach uh just your standard um four percent withdrawal and we're going to actually change this withdrawal to four percent as well just to compare the two side by side you can see uh big drops in spending and if we go to constant dollar uh you know it's constant dollars so there's no drop in spending until you run out of money at the very end in in this set of data but we can also look at the percent of portfolio and here we're going to actually go to four percent to make it consistent go back to 1968. what I found interesting was that in many ways just using a percent of portfolio while there was still pretty big changes in spending in some ways you might argue that it wasn't as bad as Vanguard Dynamic strategy in the sense that yeah it went down pretty sharply but then it recovered pretty sharply so you had a couple of bad years in here but then you recovered and actually moved back up to basically where you started now again I'm looking at an extreme case late 60s as I said we're a bad time to retire but I think a lot of these withdrawal strategies need to be tested against the extreme cases I think generally that's true but I think it's particularly true now given the the still relatively high valuations in the stock market and still relatively low interest rates obviously not as low as they were a year ago but I think we need to try to prepare for sort of worst case scenarios while of course hoping for the best so for me the Vanguard Dynamic spending rules probably not the strategy I would choose however I do think it can serve an important purpose even if you pick a different strategy it may be worthwhile to test your spending against the Vanguard Dynamic spending rule just to see how it's how it's moving along from year to year because it might help you sort of alert you to potential problems with your spending either that you're spending too much or maybe you're not spending enough maybe you could be comfortably spending a little bit more and having a a bit higher lifestyle in retirement so even if you don't end up using the Vanguard Dynamic spending rule strategy I still think it might be useful to test your approach against it from time to time just to see how you're doing so there you go that's the Vanguard Dynamic spending rule if you have any questions leave them in the comments below I'll do my best to help you out any way I can and until next time remember the best thing money can buy is Financial Freedom

Channel: Rob Berger

Views: 44,495

Keywords: vanguard dynamic spending rule, vanguard withdrawal strategy, retirement spending, 4% rule

Id: u6QNY0Minxw

Length: 19min 48sec (1188 seconds)

Published: Thu Jan 19 2023